7 risks associated with investment in fixed deposits

Understand the dangers before investing in FD. Explore potential risks to safeguard your savings and make informed decisions.
Risks associated with investment in fixed deposits
3 min
14-April-2024

When it comes to safe investment options, most investors vouch for fixed deposits (FDs). Millions of Indians prefer to park their life savings in FDs, which promise assured interest income and capital safety. Whether it be retirement planning or monthly income benefits, FDs are one of the most sought-after investment products in the country.

While FDs are largely risk-free in the sense that your returns are assured and the invested capital remains protected, there are still certain risks in fixed deposit investments. As an investor, it is crucial to assess these FD risks before parking your hard-earned savings in an FD account.

Liquidity risk: The difficulty of exit

Liquidity risk in fixed deposits arises when you must access your FD funds before maturity. While most bank and corporate FDs allow premature withdrawals, not all FDs can be liquidated. Non-callable 5-year fixed deposits do not permit premature withdrawals until the predetermined lock-in period is completed. Withdrawals from such FDs are possible only when mandated by court order due to the death of the investor or bankruptcy. Additionally, partial and complete premature withdrawals from the FD account attract a 0.5%-3% penalty charge (of the interest) that undercuts your potential earnings from the investment. In other words, such interest penalties compromise your gains from high NBFC FD interest rates.

Default risk when issuers default

Default risks in fixed deposits are quite marginal since, historically, bank defaults have been quite rare. However, theoretically, it is still a possibility investors should acknowledge. To safeguard investors, bank FDs are insured up to Rs. 5 lakh by the DICGC (Deposit Insurance & Credit Guarantee Corporation). This insurance coverage applies to each investor and includes the principal and interest sum in the FD account. A good way to mitigate this risk is to spread your FD investment across multiple banks for assurance and adequate default coverage.

Alternatively, consider allocating your funds to corporate FDs such as the Bajaj Finance FD, which boasts impressive safety ratings( ICRA AAA/Stable and CRISIL AAA/STABLE). These high safety ratings, plus attractive interest rates of up to 8.85% p.a., allow you to enjoy the lowest investment risk and highest returns.

Inflation risk takes away real value

While FDs are safe investments, they often fail to beat inflationary pressures compared to money market instruments. Inflation has the potential of eroding the real value of your saved fixed deposit corpus over time. For instance, if your FD gives you 8% returns and the current inflation rate is 5%, you get 3% as real returns. However, if the inflation rate soars to 6%, your returns go down to just 2%. Even though the returns on your FD remain the same, their real value and purchasing power decline with rising inflation. Ideally, you should diversify your investments into inflation-beating avenues like equity markets, mutual funds, ETFs, etc., to balance this FD risk.

Fixed deposits also carry interest rate risk

The interest rate risk in FDs manifests in two ways. Firstly, when you open an FD account, your funds are locked in for a predetermined period at the current interest rate. In other words, you earn fixed returns throughout the tenure of the FD. Now, if the FD interest rates rise due to a rise in the repo rate in the coming days or months, you cannot benefit from this rise since your investment is already locked in. This presents an interest opportunity loss. Secondly, while FDs offer better returns than savings accounts, the 6%-8% interest rate is still on the lower end of the spectrum compared to market-linked investments like mutual funds. Thus, when investors are curating FD checklists, it is important to consider the magnitude of this risk and pick FDs - like the Bajaj Finance FD - that offer interest rates above the 8% benchmark.

Concentration risk

Risk-averse investors prefer parking their funds in safe investment instruments like FDs. However, having your funds concentrated in just one form of investment presents its own risks. Firstly, FDs may not offer inflation-adjusted returns or help generate long-term wealth to meet your financial goals and milestones. To do so, portfolio diversification is required. Low-risk investors can opt for other investment avenues like debt funds, government bonds, and debentures to maximise their yields while minimising the overall risk.

Risk of higher taxation

This is one of the most crucial FD risks investors should assess before booking an FD. Banks deduct a 10% TDS of your FD interest if it exceeds a certain threshold. This cap is set at Rs. 40,000 for regular citizens and Rs. 50,000 for seniors. Your FD interest earnings are also clubbed with your income and taxed as per the applicable tax slab. So, if you fall under the 30% tax bracket, your returns from the FD will be lower compared to an investor in the 20% bracket, despite both investing at a 7% interest rate. This discrepancy arises because the higher tax rate reduces your effective earnings on the FD investment.

Financial plan fitment risk

Another FD risk to consider is the fitment risk vis-a-vis your overall financial plan. This risk arises when the FD’s tenure, interest rates, returns, or withdrawal rules do not align with your financial goals and liquidity needs. For instance, FD interest rates for a 5-year term may be higher than FD interest rates for a 1 year term. However, opting for a longer tenure for better returns can result in liquidity constraints, especially if you anticipate needing those funds in the near future.

Conclusion

Despite these risks, FDs play a crucial role in an investor’s financial portfolio. As safe investments, FDs offer stable returns, capital safety, and moderate yields to ground your portfolio. That said, investing in FDs alone is the real risk. Investors with a diversified portfolio of assets, including equities, mutual funds, bonds, and debentures, can balance out the nominal risks in fixed deposit investments. They can benefit from the inflation-beating returns of these market-linked instruments and enjoy higher yields without losing out on the capital safety of FD investments.

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Disclaimer

As regards deposit taking activity of Bajaj Finance Ltd (BFL), the viewers may refer to the advertisement in the Indian Express (Mumbai Edition) and Loksatta (Pune Edition) furnished in the application form for soliciting public deposits or refer https://www.bajajfinserv.in/fixed-deposit-archives
The company is having a valid Certificate of Registration dated March 5, 1998 issued by the Reserve Bank of India under section 45 IA of the Reserve Bank of India Act, 1934. However, the RBI does not accept any responsibility or guarantee about the present position as to the financial soundness of the company or for the correctness of any of the statements or representations made or opinions expressed by the company and for repayment of deposits/discharge of the liabilities by the company.

For the FD calculator the actual returns may vary slightly if the Fixed Deposit tenure includes a leap year.